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WHY THE USD IS BOTTOMING, IMPLICATIONS FOR US, WORLD MARKETS

Intro: What’s Needed For A Dollar Rally
 
We've stated repeatedly over the past months that for the USD to reverse its downtrend, it would require one or more of the following kinds of events:
  1. A panic event that caused a USD short squeeze as traders fled into the USD, and reminded traders that getting too short the USD under current market conditions of complacency, faltering risk appetite, and sovereign default risk could be dangerous.
  2. Firm evidence of improved fundamentals in the US economy that would move up interest rate increase expectations.
  3. Serious trouble for the Euro, which would force major USD support because trade in the EUR/USD currency pair by itself comprises about a third of the $3 trillion a day forex market, so moves in one pressure opposite moves in the other. Thus the EUR has been a prime beneficiary of USD weakness this year. It will be a prime victim of any USD strength.
 
Look what has happened over the past weeks.
 
1.       We got a bit of the first a little over 2 weeks ago with the breaking news of the Dubai crisis. Moody’s conclusion that no government backing is coming for a likely Dubai default on December 14th (barring a restructure agreement by about 80 creditors) reminded us this week that this story, along with damage to UK and European banks, is far from over.
2.       We got a dose of the second with the latest US  jobs reports blowing away expectations,  though the true significance of these will depend on whether it is followed by confirming improvements in jobs, spending, and other data in the coming months. Friday’s retail figures were the next piece in the puzzle, and the US holiday spending season will be significant.
3.       We’re getting growing signs of the third. This past week brought sovereign debt downgrades of Greece and Spain, and renewed attention to the parlous state of Ireland, Portugal, Latvia, Italy, and possibly others.  With many European government finances already stressed, it’s far from certain that the ECB will ride to the rescue.
 
It appears likely that we are likely be seeing more sovereign debt troubles and resulting short term panic or near panic events, with at least some of them in the Euro-zone or affecting European banks exposed to them. Thus expect more of factors 1 and 3 above. As long as the US economy is no worse than Europe’s then that alone is a partial achievement of the second.
 
Ramifications
In short,  the near term bottoming of the USD is a distinct possibility, and it is likely to have a better year vs. other currencies in 2010, despite its very real long term troubles. Note however, that many of these are shared by other currency blocks, and in forex, it’s all relative anyway, because currencies always trade in pairs, one priced in terms of another.
If that trend reversal occurs, it will reverberate throughout global stock, commodity, and currency markets. While the affects and interplay of forces would be complex, a few ramifications are likely:
 
Commodities
Short term drop in commodities bought primarily as USD hedges, especially precious metals, as gold’s recent plunge demonstrated. Ditto oil. Longer term, the general vast expansion of money supply augurs well for hard assets, though much will depend on when real recovery begins. Until then, new demand in precious metals and energy tends to have a lot of USD hedge interest in it and this fades fast when the dollar strengthens due to one of the above 3 factors.
 
Forex
The biggest effects will be felt on forex markets, because the USD is directly involved in well over 80% of all forex pair trade, and indirectly involved in most of the remaining 20%. In short, trends seen since March 2009 are likely to reverse, as the USD recovers as USD shorts continue to unwind and liquidity becomes of prime importance. The magnitude of these reversals will vary. For example, the AUD has strong underlying economic fundamentals and may hold up well. The NZD, however, does not share such underlying economic strength, though it has tended to rally along with the AUD. The same could be said for the CAD, which doesn’t even have the NZD’s relatively high interest rates.
 
Equities
A more complicated relationship in the short term. Over the recent years, the dollar’s low rates have driven investors away, causing them to return only when fear rises and they flee out of risk assets into the perceived safety of the dollar. Thus the USD has tended to move in the opposite direction of both US and international stock markets. However, when there is news that is so good for the US economy that it raises expectations for US interest rate increases, both stocks and the USD tend to rise together, as seen twice over the past year when US Non-Farms Payrolls and Unemployment reports came out much better than expected.
 
Thus bad news that raises fear and hurts stocks tends to help the dollar in the short run and vice versa. Good news for US employment, consumer spending, which in help heal the financial and housing sectors that have lead us into crisis and rally over the past years, is likely to boost both global stocks AND the USD.
 
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